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Looking at P/E the Rule Breaker Way

The Motley Fool’s Dylan Lewis and Simon Erickson discuss why you shouldn't necessarily be bothered by a lofty price-to-earnings ratio.

It's good to break with tradition. A great many analysts fervently believe that when a company reaches or exceeds a certain price-to-earnings ratio, that company is overpriced and no longer a worthwhile investment. This has been a truism in the market for many years, and it remains an unshakable core belief of many investors.

In this clip from the Industry Focus: Tech podcast, analysts Dylan Lewis and Simon Erickson explain why the Fool's Rule Breakers disagree with this school of thought, how they look at the P/E instead, and why they've seen bigger and better returns from that approach.

A transcript follows the video.

This podcast was recorded on June 3, 2016.

Dylan Lewis: One of the reasons I wanted to bring you on the show is the Rule Breaker way, and some of the ways that our premium analysts think about P/E, is quite a bit different than how a lot of people think about P/E, so you'll read articles and they'll say, "This company is a P/E of 40 and they're really overpriced. They're very expensive right now." That's not really the way that you guys think about it, right?

Simon Erickson: Yeah, that's right. A lot of it is a function where the company is but also where the market is, too. If you've got a mature market, you would expect maybe higher earnings out of the company right now. It's more mature, but if it's a new, fast-growing market, maybe you're willing to pay more for future growth out of that company.

Lewis: Some investors will categorically rule out these high-P/E companies. They're not interested in paying out for speculative growth. They're going to take your stable, low-P/E dividend payers, people that are buying tons of shares. Stuff like that. I'm going to reference an old fool.com article here. It's one from 2006. The headline is "The Highest Possible Returns." This is one David Gardner wrote a little while back. He lays out his methodology for stock selection.

I think this really great note here that kind of hammers home how some people here at the Fool think about P/Es, and just general valuation is sign No. 6, and I think this is a maybe a seven-step kind of approach for looking at a Rule Breaker, or companies that will outperform: "You must find documented proof that is overvalued according to the financial media."

The quote that he writes here is:

If a company is growing its earnings and, as a result, has an increasing valuation, there will be someone, somewhere who will argue that the company is overvalued. The reason this is valuable is because it keeps people out of a stock; later on, as the company proves out its position as a profitable, even dominant, leader, then the skeptics all finally buy.

It seems like that's kind of the approach internally, and that's the mind-set with which you're looking at some of these companies that maybe a lot of people are overlooking.

Erickson: That's exactly right. As you point out, we have "Six Signs of a Rule Breaker." This is kind of our philosophy for investing in growth, and this is our final sign: "Sign six is that it is overvalued." As you pointed out, Dylan, a lot of investors -- which, this is not a bad thing -- but just will not invest in higher-P/E companies. They want something more stable. They want to buy tobacco companies or Coca-Cola-kind of companies to just have that steady, recurring dividend stream you can count on. If you're in retirement, there's nothing wrong with that. You want that steady income coming through, but growth investing doesn't do that.

We really are looking for companies that are taking that stream of gross profit and then operating profit, which is after you pay back your R&D, your operational costs, and you're reinvesting that right back into the business. We want the companies that are going after the growth tomorrow. There's a lot more uncertainty from that, too, right? You don't know if it's going to work, so you have to look at softer factors, like, what does the management team look like, what is the vision of the CEO of this company, what is the board of directors comprised of? Those are things that are not as quantitative that you can just look at in ratios and really discern out a P/E ratio. A lot of companies that, stuff really matters for stock returns. We're going to talk about a couple of those later on the show here.

Lewis: Yeah, I think one of the other points to bring up with very high-P/E companies is they tend to be in nascent markets, so it's one that is much harder to predict the total value of that business and the market share they're going to be able to realize and just the value of that addressable market. Even if you do have a perfect understanding of that because it's nascent, a lot of people just don't understand it. It's hard to see exactly where it's going to be five or 10 years from now, whereas your big tobacco companies, your soda companies, things like that, people have a general sense of what demand is going to look like and what the big picture is for them, right?

Erickson: Absolutely. I mean, look at Facebook (NASDAQ:FB); it's a perfect example of that. A couple of years ago, Mark Zuckerberg says he's going to be paying $2 billion in an acquisition of Oculus for virtual reality. I remember seeing a lot of headlines that were laughing at this move, right? "What is he thinking? Virtual reality? We've been talking about that for three decades. No one has ever done anything with this." Now we went to the South by Southwest conference earlier this year. Right, Dylan?

Lewis: It was a blast.

Erickson: What was one of the biggest topics at this South by Southwest conference?

Lewis: Virtual reality.

Erickson: I mean, it's amazing how just in a couple of years this has gone from what are we thinking to this is a really big deal that everyone getting excited about and behind. That just shows you when you're early on in developing a new market and you're a visionary leader, you can gain a lot of reward in a lot of places that other companies are not looking at.